My most recent books are the Leader's Guide to Radical Management (2010), The Leader's Guide to Storytelling (2nd ed, 2011) and The Secret Language of Leadership (2007). I consult with organizations around the world on leadership, innovation, management and business narrative. At the World Bank, I held many management positions, including director of knowledge management (1996-2000). I am currently a director of the Scrum Alliance, an Amazon Affiliate and a fellow of the Lean Software Society. You can follow me on Twitter at @stevedenning. My website is at www.stevedenning.com.

The Dumbest Idea In The World: Maximizing Shareholder Value

“Imagine an NFL coach,” writes Roger Martin, Dean of the Rotman School of Management at the University of Toronto, in his important new book, Fixing the Game, “holding a press conference on Wednesday to announce that he predicts a win by 9 points on Sunday, and that bettors should recognize that the current spread of 6 points is too low. Or picture the team’s quarterback standing up in the postgame press conference and apologizing for having only won by 3 points when the final betting spread was 9 points in his team’s favor. While it’s laughable to imagine coaches or quarterbacks doing so, CEOs are expected to do both of these things.”

Imagine also, to extrapolate Martin’s analogy, that the coach and his top assistants were hugely compensated, not on whether they won games, but rather by whether they covered the point spread. If they beat the point spread, they would receive massive bonuses. But if they missed covering the point spread a couple of times, the salary cap of the team could be cut and key players would have to be released, regardless of whether the team won or lost its games.

Suppose also that in order to manage the expectations implicit in the point spread, the coach had to spend most of his time talking with analysts and sports writers about the prospects of the coming games and “managing” the point spread, instead of actually coaching the team. It would hardly be a surprise that the most esteemed coach in this world would be a coach who met or beat the point spread in forty-six of forty-eight games—a 96 percent hit rate. Looking at these forty-eight games, one would be tempted to conclude: “Surely those scores are being ‘managed’?”

Suppose moreover that the whole league was rife with scandals of coaches “managing the score”, for instance, by deliberately losing games (“tanking”), players deliberately sacrificing points in order not to exceed the point spread (“point shaving”), “buying” key players on the opposing team or gaining access to their game plan. If this were the situation in the NFL, then everyone would realize that the “real game” of football had become utterly corrupted by the “expectations game” of gambling. Everyone would be calling on the NFL Commissioner to intervene and ban the coaches and players from ever being involved directly or indirectly in any form of gambling on the outcome of games, and get back to playing the game.

Which is precisely what the NFL Commissioner did in 1962 when some players were found to be involved betting small sums of money on the outcome of games. In that season, Paul Hornung, the Green Bay Packers halfback and the league’s most valuable player (MVP), and Alex Karras, a star defensive tackle for the Detroit Lions, were accused of betting on NFL games, including games in which they played. Pete Rozelle, just a few years into his thirty-year tenure as league commissioner, responded swiftly. Hornung and Karras were suspended for a season. As a result, the “real game” of football in the NFL has remained quite separate from the “expectations game” of gambling. The coaches and players spend all of their time trying to win games, not gaming the games.

The real market vs the expectations market

In today’s paradoxical world of maximizing shareholder value, which Jack Welch himself has called “the dumbest idea in the world”, the situation is the reverse. CEOs and their top managers have massive incentives to focus most of their attentions on the expectations market, rather than the real job of running the company producing real products and services.

The “real market,” Martin explains, is the world in which factories are built, products are designed and produced, real products and services are bought and sold, revenues are earned, expenses are paid, and real dollars of profit show up on the bottom line. That is the world that executives control—at least to some extent.

The expectations market is the world in which shares in companies are traded between investors—in other words, the stock market. In this market, investors assess the real market activities of a company today and, on the basis of that assessment, form expectations as to how the company is likely to perform in the future. The consensus view of all investors and potential investors as to expectations of future performance shapes the stock price of the company.

“What would lead [a CEO],” asks Martin, “to do the hard, long-term work of substantially improving real-market performance when she can choose to work on simply raising expectations instead? Even if she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of her stock-based incentives. Expectations are where the money is. And of course, improving real-market performance is the hardest and slowest way to increase expectations from the existing level.”

In fact, a CEO has little choice but to pay careful attention to the expectations market, because if the stock price falls markedly, the application of accounting rules (regulation FASB 142) classify it as a “goodwill impairment”. Auditors may then force the write-down of real assets based on the company’s share price in the expectations market. As a result, executives must concern themselves with managing expectations if they want to avoid write-downs of their capital.

In this world, the best managers are those who meet expectations. “During the heart of the Jack Welch era,” writes Martin, “GE met or beat analysts’ forecasts in forty-six of forty-eight quarters between December 31, 1989, and September 30, 2001—a 96 percent hit rate. Even more impressively, in forty-one of those forty-six quarters, GE hit the analyst forecast to the exact penny—89 percent perfection. And in the remaining seven imperfect quarters, the tolerance was startlingly narrow: four times GE beat the projection by 2 cents, once it beat it by 1 cent, once it missed by 1 cent, and once by 2 cents. Looking at these twelve years of unnatural precision, Jensen asks rhetorically: ‘What is the chance that could happen if earnings were not being “managed’?”’ Martin replies: infinitesimal.

In such a world, it is therefore hardly surprising, says Martin, that the corporate world is plagued by continuing scandals, such as the accounting scandals in 2001-2002 with Enron, WorldCom, Tyco International, Global Crossing, and Adelphia, the options backdating scandals of 2005-2006, and the subprime meltdown of 2007-2008. The recent demise of MF Global Holdings and the related ongoing criminal investigation are further reminders that we have not put these matters behind us.

“It isn’t just about the money for shareholders,” writes Martin, “or even the dubious CEO behavior that our theories encourage. It’s much bigger than that. Our theories of shareholder value maximization and stock-based compensation have the ability to destroy our economy and rot out the core of American capitalism. These theories underpin regulatory fixes instituted after each market bubble and crash. Because the fixes begin from the wrong premise, they will be ineffectual; until we change the theories, future crashes are inevitable.”

“A pervasive emphasis on the expectations market,” writes Martin, “has reduced shareholder value, created misplaced and ill-advised incentives, generated inauthenticity in our executives, and introduced parasitic market players. The moral authority of business diminishes with each passing year, as customers, employees, and average citizens grow increasingly appalled by the behavior of business and the seeming greed of its leaders. At the same time, the period between market meltdowns is shrinking, Capital markets—and the whole of the American capitalist system—hang in the balance.”

How did capitalism get into this mess?

Martin says that the trouble began in 1976 when finance professor Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester published a seemingly innocuous paper in the Journal of Financial Economics entitled “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.”

The article performed the old academic trick of creating a problem and then proposing a solution to the supposed problem that the article itself had created. The article identified the principal-agent problem as being that the shareholders are the principals of the firm—i.e., they own it and benefit from its prosperity, while the executives are agents who are hired by the principals to work on their behalf.

The principal-agent problem occurs, the article argued, because agents have an inherent incentive to optimize activities and resources for themselves rather than for their principals. Ignoring Peter Drucker’s foundational insight of 1973 that the only valid purpose of a firm is to create a customer, Jensen and Meckling argued that the singular goal of a company should be to maximize the return to shareholders.

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I rather like this analysis and analogy. I have believed that the stock market is a gaming business that is totally separate from the real businesses that are supposed to underlay it. While your analogy of how management is supposed to “manage the score” is quite apt, I believe that it is foolish to think that there is any way that a publicly traded company can be managed that will make its stock and the stock market not a gaming industry. And it seems that there is no way to reintegrate the stock of any company back into the real business of the company so that the stock price reflects the true value of the company.

I realize that this is both a draconian and an heretical solution, but I think that the best thing that could ever happen for our country would be to close and vacate Wall Street and for there to be no more public trading of stock. I also realize that my idea is not likely to happen unless there is an absolute financial meltdown in this country. Even then, I suspect that the greed of Wall Streeters will not allow them to let go.

What would a world free of Wall Street look like? Since the real business of our country is not conducted on Wall Street, but on Main Street, USA, it seems to me that a collapsed Wall Street and a common understanding that the price of a stock really doesn’t reflect a company’s value, should allow the capital which was tied up and being grossly misused (really just wasted) on Wall Street to be freed to be used in the real business of this country. Properly capitalized businesses always prosper over undercapitalized ones. So, without Wall Street the people of the United States will be far more prosperous than they have ever been.

Thanks for your comment. I know that it is so frustrating to see what is going on in the financial sector that it is tempting to say, hey, let’s close it down and send these overpaid rascals back to their mansions in the Hamptons.

In my calmer moments, I am not ready to go along with that proposal in its entirety. The financial sector does after all perform some useful functions for the economy and for soceity. In the period from 1933 to 1980, we did succeed in separating the useful utility functions of banking from the trading (i.e. gambling with other people’s money). There were no financial crises in this period and we didn’t have the problem of excessive compensation. I see no reason in principle why we can’t get back to that situation in the financial sector. It means keeping the (real) bankers while sending the traders (i.e. gamblers) back to Las Vegas to play their zero-sum games and gamble with their own money. with no risk to society.

In the corporate sector, I think that the legal changes that Roger Martin proposes would help refocus management on the real economy, and effectively prevent them gaming the system.

“Executives and their companies should be legally liable for any attempt to manage expectations. Without the safe harbor provisions, there would be no earnings guidance and that would be a great thing.”

What bothers me about proposals like this is that they don’t consider the whole picture or the way the market will act. If you repeal this (and I don’t think its a bad idea), then you need to also repeal the Fair Disclosure provisions, which I believe have been one of the greatest examples of the law of unintended consequences in our financial system.

Here is what happens now. Many, not all, Companies try to game the system. They are, however, often consistent in their conservatism to the extent that the street is able to adjust their estimates accordingly. Then risk kicks in and something happens. The earnings miss Wall Streets adjusted expectations after conservative guidance. The stock tanks. Or the earnings beat the street’s expectations and the stock skyrockets. This volatility is caused by regulation FD.

What used to happen is somewhat different. There was little or no “guidance” because you really couldn’t say stuff about the future without getting in trouble. But, you were allowed to have conversations with analysts that were not public. In those conversations you could give little nudges to the expectations of the street developed by their observations and whatever conversations they had. In that environment the news leaks out slowly and stocks can be managed to their appropriate level without extreme volatility on earnings day, in either direction. Today that slow leak is illegal under regulation FD. So if you want to create a no guidance situation you need to focus on the average investor who is destroyed by volatility, and allow a little “inside” information to leak out like it used to. This creates an environment in which individual investors’ risk is reduced but where they may be somewhat disadvantaged.

The truth is that the best companies don’t reward based on stock performance. They reward based on other measures like return on equity or added economic value.

Martin is certainly correct that “maximizing shareholder value” strictly and stupidly defined as maximizing stock price is both easily manipulable and a poor measure of the “value” of the firm. Hopefully he is not arguing that the intrinsic value of the firm should not be maximized. It should. And, although customers are a part of that, merely delighting them is not necessarily everything (despite the immortal Drucker). I can be a pain in the butt, tough negotiator that makes my customer annoyed and frustrated and often unhappy. But if I produce the best product at the best price with the best service, she may not like it, and may try to find ways to get rid of me, but at the end of the day if I do that with consistency, she will be my customer and I will create value for the firm.

We should remember also that Martin’s analysis really only applies to public companies. Most companies in this country are private. In this day of Sarbox, FD, and bureaucratic and misdirected over-regulation of every aspect of the corporation, my advice is to stay private. Then you can maximize your firm’s value without any of the extraneous and ultimately only distracting difficulties of being a public company.

Thanks for these extensive and valuable comments. Staying private certainly looks like the best option if you can manage it.

“The truth is that the best companies don’t reward based on stock performance. They reward based on other measures like return on equity or added economic value.” Actually the book, “Pay Without Performance” shows that most of the extravagant executive compensation is unrelated to performance: http://www.forbes.com/sites/stevedenning/2011/11/16/why-are-fannie-freddie-ceos-paid-so-much/

An excellent book review. I’ll have to buy the book. I didn’t realize there was a name for it, but I remember when the idea of changing compensation models for executives was the rage. It was supposed to get executives focused on the long term rather than the next quarter’s earnings. It was fostered by executives who complained about their inability to think long term because everything was focused on the short term. Yes, I well remember all that and I believed it would work. Obviously , all that seems so obvious isn’t. What a mess.

I am sure that the authors of the idea of “maximizing shareholder value” were full of good intentions. But they identified a problem where there was none, and put forward recommendations that created in spades the very problem that they were worried about, in the process, helping destroy whole segments of the economy and leading directly to the economic crisis in which we now find ourselves.. Not bad for one academic article.

Thereby proving once again Keynes’s saying: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” In this case, two economists. Meckling is deceased, but Jensen is still the managing director in charge of organizational strategy at Monitor Group, a strategy consulting firm, and the Jesse Isidor Straus Professor of Business Administration, Emeritus at Harvard University.

Reading the comments and the author’s responses was interesting. I disagree with the assignment of blame to the regulators. Although not a regulator, I worked closely with the official staff responsible for regulation for over 20 years at a Reserve Bank. I also knew a lot of examiners that worked for other agencies and every one was dedicated to proper examination and defensible recommendations at the banks they examined. There were plenty of regulators who were fit to be tied over the restrictions they were subjected to, quite a few simply left their agencies because they were prevented from making needed recommendations for improvements in banks. The blame needs to be assigned to Congress. Even though the Fed is supposedly independent and occasionally acts that way, it usually wants to play along and get along so it also pays attention when there’s a “sense of Congress” kind of overarching expectation. In this case, Congress not only passed extremely risky deregulation legislation twice, but the leverage allowed investment banks was increased way beyond what is normal almost in secret. There is also the”sense of Congress” that more people owning homes is a good thing. So we have a sense that easing up on regulation of financial institutions and lowering underwriting requirements for mortgages is what Congress wants. Then there is the Treasury, responsible for a bunch of the regulatory agencies, stressing to them the need to go easy. All in all there was a lot of pressure to go easy and approve mortgages. The only idiots to blame are Congress. We must remember that Congress controls the purse strings and even the Fed is a creation of Congress, and when the Congress has a sense, everybody pays attention.